6/30/10: The Selloff

Yesterday the S&P 500 closed at a new low for 2010. Technically, this move represents a break from the range in which the index has traded for most of the past two months. However, the break was marginal; the index finished the day slightly above intraday lows reached in May.

And the breakdown wasn’t entirely convincing.

Oil was down yesterday but still traded close to $76 a barrel–roughly $10 off its May highs, but well above late-May lows in the mid-$60s. Oil prices and the stock market should be highly correlated right now; the fate of both markets depends on the health of the global economic recovery. Stock markets appear to reflect the prospects of a double-dip recession and major economic slowdown in China, but oil prices disagree: In recent weeks a recovery in US oil demand has been a major upside catalyst.

Another index to watch is the Dow Jones Transportation Average, a group that includes railroads, airlines and freight companies. Transports are highly cyclical companies that tend to get hit hard when the economy falters; many analysts regard the sector as a good gauge of economic activity. But the group failed to break its May lows and remains significantly above the 2010 lows set four months ago.

Most news outlets attributed the selling pressure to two factors: a plunge in the Chinese stock market and a big drop in the Conference Board’s measure of consumer confidence. Both issues produced plenty of sensationalist headlines, but neither move is decisive.

The Conference Board’s measure of consumer confidence fell from 62.70 in May to just 52.90 in June. At first blush, this drop appears precipitous. But the same index tumbled from 56.50 in January to 46.40 in February–an even bigger monthly decline. And in 2005 the same measure fell more than 15 points in one month, though the economy continued to grow for another two-plus years. Consumer confidence, much like consumer fashion trends and fads, is highly volatile; investors shouldn’t read too much into monthly fluctuations.

Chinese leading indicators were weaker than some had expected and suggest the economic growth is slowing from the first quarter’s red-hot pace. We’ve written about Chinese authorities efforts to cool the economy for months–this isn’t new information.

The biggest factor behind yesterday’s selloff in Chinese equities was technical: the initial public offering (IPO) of the Agricultural Bank of China. This USD23 billion IPO prompted investors to sell other holdings to make room for the banking giant.

Finally, credit markets continue to normalize. The TED spread, a widely watched indicator of health in the interbank lending markets, has declined sharply in recent sessions to about 37 basis points, well off its highs near 50 a month ago.

I am also monitoring credit spreads for European sovereign bonds, especially those of Italy, the largest of the credit-challenged EU economies. Italy’s 10-year bonds currently yield 157 basis points–1.57 percent–more than German 10-year bunds. That was up about 3 to 4 basis points from its level earlier this week but is still well off its highs of close to 180 basis points in early June.

Finally, the euro trades at USD1.22–lower than the USD1.50 it touched in 2009, but well above the USD1.18 witnessed last month. This indicates that the panic surrounding Europe continues to subside.

The breakdown in the S&P 500 is marginal and hasn’t been confirmed by several key indicators. It does little to change the short or intermediate-term picture for stocks; Friday’s employment report and next month’s earnings releases will be far more important catalysts.

The most important piece of advice I can give: Don’t panic as a result of these extreme one-day swings. Volatility will likely remain high through the remainder of the summer, as the market is heavily news-driven. Ignore the short-term news and sensationalist headlines and focus on the broader picture: This selloff is likely a correction of the bull market that started in March 2009, not the beginning of a new bear market.

No Alternatives

EU countries traditionally have subsidized alternative energy to encourage the adoption of these technologies and limit carbon emissions.

Spain recently announced that it will review its energy policy in light of the country’s strained financial position. In this era of sovereign austerity, don’t be surprised to see similar reviews in German, Italy, the UK and elsewhere. Changes could involve less generous subsidies or higher taxes on EU utilities. This all adds up to a significant problem for alternative energy firms. The US, experiencing its own financial troubles, is in no position to fill the void.

I’ve cautioned investors to avoid this group for more than a year; Spain’s announcement just confirms my view. The sector has underperformed and will continue to do so. I’m considering a few short plays in the group, most likely in solar energy. The only bright spots I see are some of the efficiency-oriented names I recommend in the Alternative Energy Field Bet and Gushers recommendation Spirit Aerosystems (NYSE: SPR).

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